How to Maximize Tax Benefits in Your College Funding
If the stress surrounding paying for college is on your mind, you’re not alone. The average cost of attendance for an in-state public school is over $25,000 per year and more than $53,000 per year for private schools. And, although Covid-19 and the pandemic slowed the rate of college price increases as enrollment declined and schools moved to online classes, high college costs remain a reality.
Successful college funding requires a multi-pronged approach. And one tool that can benefit families is tax savings. There are a variety of tax benefits that come with saving for and paying for college and can help you get the most out of your money.
The Basics of College Funding Tax Strategies
College funding tax strategies are becoming more prevalent as inflation and economic uncertainties reach an all-time high. Financial aid for college will not usually cover 100% of the growing costs, which is where saving for college years before your kids attend is a smart option. The Federal and most State governments realize the mounting cost concerns, which is why they have plans in place to assist you save, such as a 529 plan or employer assistance programs. When the time finally rolls around and your kids are choosing the right college for them, there are credits and deductions you can take for qualifying expenses. Both options result in lower taxable income, saving you money on that pesky tax bill.
Deductions vs Credits: What’s the Difference?
There are two main categories of college saving tax benefits that you claim on your tax return: deductions and credits. Deductions reduce the income you are taxed on while credits reduce your overall tax bill dollar for dollar. Credits carry more weight compared to deductions, nevertheless, both are helpful to save money on taxes for expenses you are already paying. Kiplinger outlines common tax deductions and credits to be on the lookout for:
Deductions
- Tuition and Fees Deduction – Up to a $4,000 deduction for married filers for qualifying education expenses when you don’t claim the American Opportunity Tax Credit.
- Deduction for Self-Employed Work-Related Education – A deduction for maintaining or improving your current skill set as it relates to your primary business. Costs for minimum educational requirements do not qualify.
- Student Loan Interest Deduction – A deduction for student loan interest paid with a cap at $2,500 per year.
Credits
- American Opportunity Tax Credit – One of the most beneficial credits for parents, this credit allows you to deduct $2,500 off your tax bill for 4 years for expenses at a qualifying institution.
- Lifetime Learning Tax Credit – A credit after all 4 years of the American Opportunity Tax Credit is used, allowing households to take $2,000 off their tax bill.
As with anything, there are phase-out limitations to be aware of, especially for the credits. The IRS has a great comparison table for the American Opportunity Tax Credit and Lifetime Learning Credit, going into detail on the requirements, phase-out limitations and eligible expenses.
Plans to Give You a Head Start
Deductions and credits are a great strategy for reducing expenses in the year they occur, but what about college preparation for high schoolers? Different college saving plans can bridge the gap between financial aid for college and the cost of attending. Perhaps, the most common type of college savings plan that comes with added tax benefits is a 529 Plan. Money put into a 529 Savings Plan grows tax-free with no distribution penalties as long as the money is used for qualifying expenses, including room and board. Maximizing your 529 College Savings Plan is a great way to allow your investments to grow and take advantage of tax breaks on your State return. Additional options exist as well, including:
- Coverdell Education Savings Accounts – Similar to a 529 Plan, but there are more restrictions on who can contribute to this account type.
- Scholarships, Fellowships and Other Assistance – Most of your children with college student success can be eligible for a scholarship or grant through their university or State government. However, these take time to apply for and aren’t guaranteed.
- Employer Provided Assistance – Some employers choose to pay for a portion of education expenses if it benefits your current job position.
- Education Savings Bond Program – Bonds cashed in for educational expenses qualify as a tax-free distribution, significantly saving on your next tax bill.
- Student Loan Cancellation and Repayment Services – In some circumstances, loan providers give abatement for student loans owed, however, this generally only occurs in rare situations.
The Impact of Borrowing from IRAs or 401Ks
Early distributions from an IRA or 401k are subject to a 10% early withdrawal penalty unless certain situations occur. One of those situations is using the funds for educational expenses. The penalty is waived if the money is paid directly to the education institution and the funds are for you, your spouse, your children, or a grandchild. Keep in mind that withdrawals from an IRA or 401K should be a last resort option after all other funding avenues are exhausted because of the significant impact it will have when you go to retire. Instead of reducing the income you will have when retirement rolls around, plan ahead and open up a college savings account. The tax benefits and your future retirement income will thank you.
Next Steps
Saving for college can seem overwhelming at first but getting a head start will make all the difference when it’s time to send your kid off to college. But, no matter where you are in your college savings, don’t stop, keep going. Remember, that you don’t have to contribute thousands of dollars every month. Instead, contribute extra income each month or a couple hundred dollars here or there, and definitely make it easy for others to contribute to your accounts by using online gifting platforms. The tax-saving growth will add up, giving you more peace of mind when that first college tuition bill arrives.
Additionally, contacting an accountant and frequently referencing IRS Publication 970 will help you stay up to date and on top of all legislation changes. The more informed and prepared you are, the better chances for college funding success.
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